At the end of 2008 everyone was certain that investments in resource stocks were dead money, but 2009 proved to be one of the sector’s best years. The question now is whether the run will continue.

We believe this uptrend will continue, though a correction is always a possibility–investors may be eager to protect profits. That caveat aside, Chinese demand remains robust and recent statistical releases indicate that the rest of the world is also restocking.

Although the latter isn’t as strong as it should be after such a pronounced slump in demand, the wave of restocking should be enough to sustain higher prices. Given this scenario, the last bears will knuckle under, unable to ignore rising resource prices.

On the other hand, if Chinese demand and consumption surprise to the downside, the global mining sector would suffer a severe blow. Any governmental efforts to curb speculation or encourage protectionism would be another negative indicator for the group.

Nevertheless, our working thesis for the first half of 2010 involves elevated metal prices, and we recommend that investors focus on larger, diversified miners.

Portfolio’s 2020 long-standing recommendations BHP Billiton (NYSE: BHP) and Brazilian iron ore producer Vale (NYSE: VALE) are perfect choices.

And today we’re adding one more company to the mix: China Metal Recycling (Hong Kong: 0773), one of the leading scrap metal recyclers in China.

The company purchases scrap steel, copper and other metals from suppliers worldwide, using heavy equipment and manual labor to sort the scrap and produce recycled scrap products.

Metal manufacturers in China use its products to produce new crude steel and other non-ferrous metals. These materials, in turn, are used in the production of a wide range of end products, including construction materials, heavy equipment, automobiles, aircraft, ships and household appliances.

This is a leveraged play on China’s urbanization process, elevated metals prices and a move toward a more environmentally friendly economy. The latter has become very important in China; contrary to what the popular press would have people believe, China is implementing alternative energy in an aggressive fashion.

The Chinese won’t destroy economic growth for the environment’s sake, but they’re further ahead in the green energy game than a lot of industrial economies and ages ahead of any other major developing economy.

Industries that have operations that also benefit the environment will be important to China and, consequently, should receive support from the central government. Metal recycling is one of these industries.

As early as 2005, China’s State Council approved the Steel Industry Development Policy, which included guidelines for sustainable development of the steel industry and advised steelmakers to increase their use of recycled scrap steel in steel manufacturing and replace small mills with larger ones.

The scrap business occupies a unique place in emerging markets in that these countries generate less scrap but have a high demand for scrap metals. For example, China is the world’s largest consumer of ferrous and non-ferrous scrap, accounting 16 percent of the former market and 31 percent of the latter.

China has produced 4 billion tons of steel since 1960, 74 percent which was produced over the last 15 years–the dividing line between new steel and scrap steel.

As a result, a lot of this steel has not “aged” enough to be used as scrap, and scrap supply in China should remain tight domestically for at least this year.

The metal recycling business in China is young and in the early stages of expansion. The market is very fragmented: The top 10 scrap processors accounted for around 12 percent of the domestic market share; in contrast, the top 10 steelmakers control around 40 percent of market share.

China Metal Recycling has expanded its business in four locations in China, and plans to increase total capacity at these facilities from 1.6 million tons in 2008 to 3.6 million tons in 2010. The company is already the leader in south China and is in the early stages of expanding in the eastern, northern and central markets.

The scrap recycling market is highly cyclical, and scrap prices take a hit in times of slow economic growth or recession. As the chart shows, China’s domestic scrap prices rose substantially from January 2006 to a high of RMB4,117 per ton in August 2008. Then prices lost more than 50 percent, bottoming in November 2008 at RMB1,959 per ton.


Source: Bloomberg

China Metal Recycling will benefit in the short and long term if our expectation for stronger metal prices is correct.

On the risk side, CMR’s chief financial officer left the company in November after accusing management of faulty corporate governance practices. The stock dropped dramatically on the news and hasn’t recovered.

If these accusations are valid, it would be a setback for the stock. But the ensuing months haven’t revealed the exact problem–if, indeed, there is any cause for concern. The situation bears close monitoring but also provides prospective investors with an attractive entry point.

China Metal Recycling is the newest addition to the Metals & Materials Portfolio. Buy China Metal Recycling up to HKD10 on the Hong Kong exchange to ensure sufficient liquidity. 

Yiannis Mostrous is associate editor of Portfolio 2020 and editor of Silk Road Investor.